One for the Time Capsule

It was one more unsettled week for global financial markets, as equities,
bonds, currencies, and commodities all seemingly traded with dizzying volatility.
Our stock market was choppy, but ended the week little changed. The Dow, S&P500,
Transports and Morgan Stanley Cyclical indices posted fractional declines.
The Utilities added 1% and the Morgan Stanley Consumer index enjoyed a slight
gain. The broader market was largely unchanged, with the small cap Russell
2000 slightly positive and the S&P400 Mid-cap index slightly negative.
The NASDAQ100 was flat for the week. The highflying technology sector generally
underperformed. The Morgan Stanley High Tech index declined 1% and the Semiconductors
dipped 2%. The Street.com Internet Index lost 1%, while the NASDAQ Telecommunications
index was unchanged. The Biotechs posted a 2% gain this week, increasing 2003
gains to 42%. The financial stocks were mixed, with the Broker/Dealers up 1%
(y-t-d up 42%) and the Banks down 1%. Todays $4.90 drop left gold with a $2.90
decline for the week. The HUI gold index was largely unchanged.

The dollar index declined better than 1% this week. During the second half
of August, the Euro dropped from 113 to about 108 during just seven sessions.
Over the past seven trading days, the Euro has now rallied back from 108 to
113. Some kind of volatility...

Venezuela sold $700 million of 10-year bonds (12.4% yield), its first issuance
in two years.

September 11 - Dow Jones (Sonja Ryst): "As hungry buyers continue bidding
up the prices on government and corporate debt from emerging markets, three
big-name issuers came to market on Thursday, kicking off what's expected to
be a busy few weeks of issuance... 'The markets are poised to have issuance
from everywhere in the next couple weeks,' said Mike Conelius, a portfolio
manager at T. Rowe Price... J.P. Morgan said in a recent report that $11 billion
in emerging market debt issuance remains to be completed this year and that
$32 billion had been placed so far... Debtors haven't been able to raise international
bond funding at such low cost in years. The J.P. Morgan Emerging Markets Bond
Index Plus, or EMBI+, is trading at around 475 basis points over comparable
U.S. Treasurys. The last time the EMBI+ went below 480 basis points was on May
5, 1998."

Today from Bloomberg's hardworking William Pesek: "Speculators, that international
cast of financiers who helped fuel the Asian crisis, are again at Thailand's
gate. Barbarians to some, savvy market punters to others, speculators have
rediscovered the Thai currency. Only this time, instead of driving the baht
lower, as they did in 1997, speculators are driving it up." (It is today worth
reminding readers that speculators generally don't drive markets down when
they are coming in, but rather when they are keen to exit)

Commodity Watch:

September 12 - Market News International: "Core raw materials prices soared
in August by the most since 1979, boosted by scrap metals and leather..."

Today's better than 1% drop left the CRB commodities index with a slight decline
for the week. A poor crop in China and the U.S. drought were used as explanations,
as Cotton traded to an almost three-year high this week. Soybeans jumped to
a 3-month high. According to the U.S. Mint, American Eagle gold coins are selling
at the strongest rate since 1999.

Global Reflation Watch:

September 11 - Bloomberg: "China's money supply grew at a record pace in
August, which may prompt the central bank to take additional action to
curb bank lending in coming months. M2, the broadest measure of money
supply rose 21.6 percent from a year earlier to 21 trillion yuan ($2.5
trillion), after climbing 20.7 percent in July... That exceeds the bank's
18 percent growth target... Banks are eager to lend as they are awash
with cash. Household savings rose 18 percent to a record 10.7 trillion
yuan in the year ended August 31..."

September 10 - Bloomberg: "China's factory production rose in August
at its fastest pace in five months and exports surged... Production grew
17.1 percent from a year earlier to 350 billion yuan ($42 billion), after
rising 16.5 percent in July..."

September 10 - Bloomberg: "China's exports grew by more than a quarter in
August as companies such as Broadcom Corp. and Wal- Mart Stores Inc. bought
more Chinese-made semiconductors, clothes and toys. Exports grew 27 percent
to $37.4 billion after climbing 31 percent in July... 'We're growing very fast
in China,' said Yuan Yi, China country manager of Broadcom Corp., the world's
largest maker of cable-modem chips.... Wal-Mart Stores Inc., the world's biggest
retailer, said it plans to raise its purchases from China by a quarter to $15
billion this year."

September 8 - Bloomberg: "Thailand's exports in August probably rose 10 percent
(exports actually jumped 13%, up from July's 4.5%) to a record $6.9 billion
because of a surge in demand for electronics and other products, Commerce Minister
Adisai Bodharamik said, citing preliminary data... Rising exports prompted
the finance ministry last month to raise its economic growth forecast by one
percentage point to 7.1 percent. Exports have, on average, risen 18 percent
this year because of a surge in shipments to China and other
Asian nations..."

September 11 - Bloomberg: "Thailand's new vehicle sales rose 18.7 percent
in August from a year earlier to 42,453 units... For the first eight months
of the year, automobile sales rose 33 percent to 334,422 units..."

September 12 - Bloomberg: "Indian industrial production grew faster than expected
in July as lower taxes and interest rates led consumers to buy more cars and
heavier monsoon rains lifted the confidence of farmers... Industrial production,
which accounts for a quarter of Asia's No. 3 economy, rose 6.5 percent... The
cheapest borrowing costs in three decades and lower taxes are encouraging consumers
to spend." (The Indian Rupee traded to a three-year high this week.)

September 9 - Bloomberg: "A measure of Australian companies' sales, profit
and hiring rose to its highest in almost nine years in August, signaling the
economy is likely to recover from its slowest quarterly growth in 2 1/2 years,
National Australia Bank Ltd. said." Yesterday it was reported that Australia's
unemployment rate dropped to the lowest level since 1990.

September 12 - The Australian: "Australian mining corporations are increasing
their investment to supply the growing market in China. Rio Tinto and BHP Billiton
aremaking new investments to increase their production of iron ore. It is
predicted thatChina will increase its steel making capacity by
between 40 per cent and 50 per cent in the seven years from 2003."

Russian industrial production jumped 6.6% during the first eight months of
2003.

August Producer Prices jumped 0.4%, with y-o-y gains of 3.4%. August 2002
had y-o-y Producer prices down 1.5%. Year-to-date, Producer prices have increased
at a 4.4% annual rate. It was reported this week that health insurance premiums
jumped 14% this year, the strongest rise since 1990.

Freddie Mac posted 30-year mortgage rates dropped 28 basis points to 6.16%,
the lowest borrowing cost in six weeks. One-year adjustable rates dropped 11
basis points to 3.87%, down from the year ago 4.32% and only 42 basis points
higher than the lows established in late June. Adjustable rate mortgages accounted
for 21.6% of the total last week. The Mortgage Bankers Association application
index was distorted by the Labor Day holiday, so we'll return to application
data next week.

Countrywide Financial reported a significant drop in mortgage financings from
July's record. August Total Fundings declined 21% from July to about $41 billion.
This was, however, up 93% from August 2002. Refi fundings dropped 26% during
the month, while Purchase fundings were down only 6%. Purchase fundings were
up 51% y-o-y. Interestingly, Home Equity fundings actually rose 4% during the
month to $1.77 billion and were up 72% y-o-y. Subprime fundings declined only
4% during the month to $1.65 billion and were up 133% y-o-y. "Total assets
at Countrywide Bank...rose to $15 billion, an increase of 7 percent from last
month and nearly 300 percent more than August 2002."

Throughout the mortgage-dependent U.S. financial system, players are now forced
to adjust to significantly fewer originations and an abruptly competitive environment.
This week Washington Mutual reported that mortgage origination volume had dropped
40% and that competitive market conditions would reduce gains recognized on
new mortgages. National City also cut its earnings forecasts. Mortgage real
estate investment trust (REIT) Annaly Mortgage announced that it would cut
its dividend by at least half. Management blamed the previous refi boom and
heavy prepayments of higher-yielding mortgages. Over the past four quarters,
Annaly ballooned its balance sheet 30% to $14.7 billion. The company has shareholders
equity of $1.16 billion.

The July Trade Deficit was reported at $40.3 billion. Year-over-year, Goods
Imports were up 8% to $105.8 billion, while Goods Exports increased 3% to $60.5
billion. July Goods Imports were 75% greater than Goods Exports. Year-over-year,
Crude Oil imports were up 31.4%, Pharmaceuticals 20.3%, Apparel 12.3%, Food & Beverage
8.6%, and Services 8.3%. Capital Goods imports were up 2.5%. Examining Goods
Imports y-o-y by region, Western Europe was up 3.9%, Eastern Europe 48.9%,
Latin America 12.5%, Pacific Rim 6.2% and OPEC 24.2%. Y-t-d by largest trading
partner, imports from Canada were up 7.2%, China 24%, Mexico 2.2%, Japan down
0.6%, and Germany up 13.7%. Other countries of note include y-t-d imports from
Saudi Arabia up 68.4%, Brazil up 19.3%, Russia up 55.7%, and India up 13.9%.

This is an extraordinary, fascinating, historic period for Credit Bubble analysis.
And if there were doubts that the Credit Bubble had entered the precarious "blow-off" stage,
the Federal Reserve's second quarter Z1 "flow of funds" report certainly provides
ample evidence. It's One for the Time Capsule.

To begin, it is worth mentioning that in the 21 quarters prior to the second
quarter (since the beginning of 1998) total Credit Market Borrowings (Non-financial
and Financial) surged 51% - or $10.9 Trillion - to $32.1 Trillion. After an
extended period of historic excess, Credit growth has now gone "parabolic." During
the second quarter, Total Credit Market Borrowings expanded at an (seasonally-adjusted)
annualized rate of $3.35 Trillion (10.4%). This was a pace 27% greater than
the previous record posted during 2002's fourth quarter.

Led by record federal and household borrowings, Non-financial debt expanded
at a 12% rate, double the first quarter. One has to go all the way back to
1985 to find a year with stronger Non-financial debt expansion. The federal
government increased borrowings at a 24.3% annual pace. Total Non-financial
Credit increased an unprecedented $631 billion during the quarter to $21.6
Trillion. Since the beginning of 1998, Total Non-financial Credit has jumped
$6.40 Trillion, or 42%. Over this same period, GDP increased $2.54 Trillion,
or 31%. Thus, over the past 22 quarters, Total Non-financial Credit has increased
from 184% of GDP to 200%. Non-financial Credit was about 140% of GDP back in
1980. Since the beginning of 1998, Financial Sector Credit Market Borrowings
have surged $5.30 Trillion, or 97%, to $10.76 Trillion. Financial borrowings
as a percentage of GDP have jumped from 66% to 100%. Total Credit Market borrowings
(Non-financial and Financial) have surged $11.7 Trillion, or 57% over 22 quarters.
As a percentage of GDP, Total Credit has increased from 250% of GDP to 300%.

And while Federal debt issuance was extraordinary during the quarter, borrowing
excesses were anything but confined to our nation's capitol. From the text
released with the Fed's Z1: "The pickup in debt growth in the second quarter
was distributed broadly across all of the major sectors in the United
States..." The Household Sector increased borrowings by an unprecedented
$1.0 Trillion annualized, or 11.5%. One has to again go back to 1985 to find
a year with a greater rate of debt expansion. To put the $1 Trillion pace of
borrowings into perspective, the Household Sector increased borrowings by $330.8
billion during 1997, $450.8 billion during 1998, $498.6 billion during 1999,
$558.8 billion during 2000, $614.6 billion during 2001, and $771.8 during 2002.
Elsewhere, State and Local Governments increased borrowings at a 12% annualized
rate. Non-financial Corporate bonds were issued at an annualized pace of $309.6
billion, the strongest growth since Q2 2001. Corporate debt expanded at 6.3%
annualized. This was more than double the first quarter's rate and compares
to 2002's growth of 1.2%.

Total Mortgage Credit (home and commercial) expanded at an unprecedented $1.14
Trillion annualized (14.3%). This was 30% greater than 2002's record annual
debt growth. During the first half, Total Mortgage Credit expanded at a rate
of $1.01 Trillion (12%). This compares to 2002's $879.6 billion, 2001's
$700.4 billion, 2000's $570.1 billion, 1999's $568.5 billion, 1998's $510.6
billion and 1997's (pre-Bubble) $337.3 billion. During the second quarter,
Home Mortgage Credit expanded at an amount almost 370% of the debt growth from
(pre-Bubble) 1997. Home Mortgage Borrowings expanded at an unprecedented $951.4
billion, or 14.3% annualized. This compares to 2002's $721.2 billion, 2001's
$532.7 billion, 2000's $418.2 billion, 1999's $424.4 billion, 1998's $384.6
billion, and 1997's $258.3 billion.

It is also worth noting that Home Equity Loans (included in Home Mortgage
Borrowings) expanded at an unprecedented $174.8 billion annualized, or 20%
rate. This compares to 2002's record growth of $129.8 billion. Home Equity
debt expanded $68.8 billion during 2001, $97.8 billion during 2000, $56.0 billion
during 1999, and $60.6 billion during 1998.

Since the beginning of 1998, Total Mortgage Debt has expanded $3.71 Trillion,
or 70.5%, to $8.96 Trillion. Over these 22 quarters, Home Mortgage Debt surged
$2.99 Trillion, or 72%, to $6.88 Trillion. Over this period, Total Mortgage
Debt jumped from 62% to 84% of GDP, while Home Mortgage Debt has increased
from 47% of GDP to 64%.

Financial sector expansion was all-encompassing. Credit Unions increased assets
at a 16.7% rate during the quarter (up 12.3% y-o-y). Finance Companies increased
assets at a 17% rate (up 8.8% y-o-y). Real Estate Investment Trusts (REITS)
expanded at a blistering 34.7% rate during the quarter to $101.0 billion, with
12-month gains of 18.7%. The Fed expanded its assets by 11% annualized to $769,
with first-half growth at almost 12% annualized. Curiously, Foreign Banking
Offices in the U.S. decreased Net Acquisition of Financial Assets at an annualized
$116.6 billion.

GSE asset holdings expanded at a 9.3% rate during the quarter to $2.66 Trillion,
with y-o-y gains of 11.5%. GSE assets are up $1.56 Trillion, or 142%, since
the beginning of 1998 (22 quarters). Mortgage-backed Securities (not retained
by GSEs) expanded at a 7.8% rate during the quarter to $3.29 Trillion, with
y-o-y gains of 8.1% (up $1.46 Trillion, or 80.1% over 22 months). Asset-backed
Securities (ABS) expanded at a 12.1% annualized rate during the quarter to
$2.51 Trillion, with a 12-month rise of 11.9%. ABS have surged $1.524 Trillion,
or 154.3%, since the beginning of 1998. Combined "Structured Finance" (GSE,
MBS, & ABS) expanded at a 9.5% rate during the quarter to $8.46 Trillion.
During the past year, "Structured Finance" liabilities increased $789.3 billion,
or 10.3%. Over 22 months they inflated an amazing $4.55 Trillion, or 116.2%.
It is also worth noting that Mortgages accounted for 82% of new ABS assets
during the second quarter, compared to 39% during 2000, 47% during 2001, and
49% during 2002.

The "flow of funds" report includes a Credit category "Federal Funds and Repurchase
Agreements," combining two key security financing mechanisms used throughout
the Credit system (for leveraged securities speculation). Recalling the "melt-up" that
enthralled the Credit market during the second quarter, we would expect to
see evidence of extreme use of financial sector borrowings to finance speculation.
Such is the case and it's conspicuous. For the quarter, Federal Funds and Repurchase
Agreements expanded an unprecedented $564.3 billion annualized, a growth rate
of 43%. For perspective, Fed Funds and Security Repurchase Agreements expanded
$105.0 billion during 2002, $22.3 billion during 2001, $113.2 during 2000,
$169.8 billion during 1999 and $91.3 billion during 1998. (One would assume
that the financial sector used this funding source aggressively to partially
finance the unprecedented Treasury debt issuance boom and the continued enormous
quantity of Agency debt issued.) Total Security Credit expanded at an unprecedented
$160.8 billion ($643.2 billion annualized!) to $957.4 billion. Total Security
Credit was up 28.4% y-o-y, and has more than doubled since the beginning of
1998. As always happens, the speculators loaded up at the top of the market.

And with the U.S. Credit Bubble in the midst of blow-off excess, the world
is being inundated with dollar liquidity. Yet there is little international
interest in real economic investment in the high cost U.S. economy. By default,
our foreign trading partners (much through their central banks) are accumulating
holdings of U.S. financial assets like never before. From the Z1, the second
quarter saw Rest of World Net Acquisition of US Financial Assets of $959.6
billion annualized, or 14.6%. The composition of these purchases is notable.
Holdings of Credit Market Instruments increased $1.06 Trillion annualized,
almost double the previous record established during Q4 2001. Holdings of US
Government Securities (Treasuries and Agencies) increased at an unprecedented
$688.7 billion pace, or 35.9% annualized. For comparison, Rest of World increased
holdings of US Government Securities by $362.7 billion last year, $234.6 billion
during 2001, and $129.5 billion during 2000. Conversely, Foreign Direct Investment
(FDI) increased $53 billion annualized (3.4%) during the second quarter, a
fraction of 2000's $321.3 billion increase in FDI.

Since the beginning of 1998, Rest of World holdings of U.S. financial assets
have surged $2.98 Trillion, or 64%. Foreign holdings have jumped from 57% of
GDP to begin 1998 to 71% by the end of the second quarter.

Supported by extraordinary Credit-induced inflation, total Household (included
Non-profits) asset values jumped an eye-opening $2.0 Trillion during the quarter
(17% annualized) to a record $50.54 Trillion. Since the beginning of 1998,
Household asset values have surged $10.9 Trillion, or 28%. Over the past 12
months, the total value of Household assets is up $2.2 Trillion (real estate
almost $1 Trillion to $14.1 Trillion, financial assets almost $1 Trillion to
$32.0 Trillion, and Other about $200 billion to $4.4 Trillion). And despite
a surge in Household borrowings (expanding 15% annualized to $9.3 Trillion),
Household Net Worth jumped $1.7 Trillion during the quarter, or almost 17%
annualized, to $41.4 Trillion. There remains little mystery as to why consumer
borrowing and spending remains so resilient: Asset Inflation.

Today the Office of the Comptroller of the Currency released its second quarter
Bank Derivatives Report. "Uncertainty in financial markets continues to drive
banks and their customers to seek risk mitigation opportunities through the
use of derivatives..." Well, I would argue that the continued explosion in
derivative growth is a peculiarity of contemporary finance and its out of control
Credit Bubble. For the quarter, total derivative positions held by the major
U.S. banks jumped $4.4 Trillion, or 27% annualized, to $65.8 Trillion. By category,
Interest Rate derivatives were up 24% annualized to $56.9 Trillion, Foreign
Exchange 48% annualized to $7.1 Trillion, Credit derivatives 46% annualized
to $802 billion, and Other declined 4% annualized to $1.0 Trillion. By product,
Futures & Forwards jumped 24% annualized to $12.7 Trillion, Swaps 25% annualized
to $38.1 Trillion, and Options 34% annualized to $14.3 Trillion. JPMorgan Chase
derivative positions increased to $32.7 Trillion (25% rate), Bank of America
$13.8 Trillion (23% rate), and Citibank $11.0 Trillion (33% rate).

Milton Friedman interviewed this week on CNBC: "I don't believe there is any
New Economy at all in that sense (unique surge in productivity). There was
the same talk in the 1920's. The 1920s were a period very much like the 1990s
in which we had a tremendous surge of productivity in the United States during
that ten year period. This time the big difference is in the way in which
the Federal Reserve handled the monetary reaction. And as a result, you
had a very mild recession and there was nothing to cut productivity down drastically."

It is certainly no coincidence that so-called productivity "miracles" were
trumpeted during respective 1920s and 1990s Credit Bubbles. Simplistically,
Credit and speculative excess, along with resulting asset inflation, stoked
abnormal spending (business and consumer) and "output" (including "upscale" and
luxury goods and services). And, especially after examining the Credit data
from above, it is not the least bit surprising that talk of the Productivity
miracle has gone "parabolic." This is, after all, consistent with the blow-off
stage of the Great Credit Bubble. Everything seems to lose its bearings.

Dr. Friedman's calamitous error (which is perfectly consistent with his flawed
analysis of the causes of the Great Depression) is to believe that the Fed
has "handled" the situation adeptly and successfully. Dr. Freidman, along with
so many others, is analyzing the situation incorrectly. The reality of the
situation is that the Fed has not "handled" anything other than prolonging
an increasingly dangerous Bubble.

Any serious analyst - operating from a sound analytical framework - delving
into the Fed's "flow of funds" data can come to some important conclusions.
First, there is no mystery surrounding the economic pickup; it's conspicuously
induced by unprecedented Credit excess. The "mystery" is why the economy is
not much stronger. Second, with Credit expanding dramatically in excess of
investment or even economic (distorted as it is) "output," rising asset prices
(stocks and real estate, in particular) also constitute no enigma. There is
today unprecedented liquidity fueling destabilizing asset inflation. Third,
Credit and speculative excesses have reached unprecedented extremes. Total
Credit Market Borrowings (in excess of $32 Trillion, or three times GDP) are
now expanding at a rate close to 10%, with Non-financial debt growing at low
double-digits. Textbook Blow-off.

What is admittedly not clear is the duration of this fateful blow-off phase.
There are clearly powerful forces at work sustaining this historic Bubble.
But uncertainty does not mean this "Cassandra" will back down. For too many
years we've witnessed the unstable U.S. and global financial systems nurture
repeated "miracle" booms and subsequent devastating busts. We watched repeated
blow-offs, and their manic existence was measured in quarters and not years.
Today, we're just witnessing The Big One. And there is simply no way around
the very harsh reality that current extraordinary Credit and speculative excesses
are setting the stage for financial and economic instability unlike anything
experienced in a very long time. Rampant asset inflation and lurching economies
are seductively un-enduring inflationary manifestations.